Final Regs Allow Carryover of Passive Activity and At-Risk Losses to Bankruptcy Estates

 [4830-01-u]

 ACTION: Final regulations.

 SUMMARY: This document contains final regulations relating to the application of carryover of passive activity losses and credits and at risk losses to the bankruptcy estates of individuals. The final regulations affect individual taxpayers who file bankruptcy petitions under chapter 7 or chapter 11 of title 11 of the United States Code and have passive activity losses and credits under section 469 or losses under section 465.

 DATES: These regulations are effective May 13, 1994.

 These regulations apply to bankruptcy cases commencing on or after November 9, 1992. In addition, the regulations apply, at the election of the affected taxpayers, to cases that commenced before, and end on or after, November 9, 1992.

 FOR FURTHER INFORMATION CONTACT: Amy J. Sargent of the Office of Assistant Chief Counsel (Income Tax & Accounting), Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC 20224, or telephone (202) 622-4930 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

The collection of information contained in these final regulations has been reviewed and approved by the Office of Management and Budget in accordance with the requirements of the Paperwork Reduction Act (44 U.S.C. 3504(h)) under control number 1545-1375. The estimated annual burden per respondent varies from .5 hour to 1.5 hours, depending on individual circumstances, with an estimated average of 1 hour.

 Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be sent to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, PC:FP, Washington, DC 20224, and to the Office of Management and Budget, Attn: Desk Officer for the Department of Treasury, Office of Information and Regulatory Affairs, Washington, D.C. 20503.

BACKGROUND

 This document contains final Income Tax Regulations (26 CFR 1) under section 1398 of the Internal Revenue Code (Code). On November 9, 1992, the IRS published in the Federal Register a notice of proposed rulemaking designating passive activity losses and credits under section 469 and unused section 465 losses as attributes that pass from the debtor to the bankruptcy estate under section 1398(g) of the Code and that, upon termination of the estate, pass from the bankruptcy estate to the debtor under section 1398(i). Corrections to the Notice of Proposed Rulemaking were published in the Federal Register on December 22, 1992 (57 FR 246). A public hearing was held on January 25, 1993. After consideration of the public comments regarding the proposed regulations, the final regulations adopt the rules contained in the proposed regulations without substantive change. A discussion of the public comments is set forth below.

PUBLIC COMMENTS

 The comments received by the IRS were generally favorable, welcoming the designation of attributes under section 1398(g)(8). Several commentators suggested that the regulations be modified. These suggestions are discussed below.

I. Expansion of the Proposed Regulations to Include Additional Attributes

 The proposed regulations designate passive activity losses and credits under section 469 and losses under section 465 as attributes that pass from the debtor to the estate. Several commentators suggested that the scope of the proposed regulations be expanded to include additional attributes of the debtor, either by specifically listing the additional attributes or by providing that attributes of the debtor pass to the estate if they are related to property passing to the estate or are in the nature of a carryforward.

 These suggestions were not adopted in the final regulations. The treatment of other unenumerated attributes under section 1398(g) and (i) is more appropriately provided in a separate regulation project. This would provide taxpayers with an opportunity to comment before additional attributes of the debtor are designated, by final regulation, as attributes that pass to the estate.

II. Taxation of Estate's Transfers of an Interest in a Passive Activity or Former Passive Activity or an Interest in a Section 465 Activity Before Termination of the Estate

 The proposed regulations provide that if, before the termination of the estate, the estate transfers an interest in a passive activity or former passive activity to the debtor (other than by sale or exchange), the transfer is not treated as a disposition for purposes of any provision of the Code assigning tax consequences to a disposition. By way of example, the proposed regulations state that such transfers include transfers from the estate to the debtor of property that is exempt under section 522 of title 11 of the United States Code and abandonments of estate property to the debtor under section 554(a) of such title. The proposed regulations provide similar rules for the transfer of a section 465 activity.

 Several commentators objected on the grounds that these provisions are outside the scope of the regulatory authority of the IRS under section 1398(g) and (i). In general, these commentators maintained that the regulatory authority of the IRS is limited to listing attributes that pass from the debtor to the estate and that, upon termination of the estate, pass to the debtor. In addition, one commentator contended that the provisions relating to pre-termination transfers between the estate and the debtor constitute an improper attempt to amend by regulation the express language of section 1398(f)(2). Commentators also questioned the treatment of abandonments as nontaxable dispositions, reiterating many of the arguments set forth in In re A.J. Lane & Co., 133 B.R. 264 (Bankr. D. Mass. 1991), which stated in dicta that abandonments are taxable dispositions. See also In re Rubin, 154 B.R. 897 (Bankr. D. Md. 1992).

 The final regulations retain the rules of the proposed regulations. Although section 1398 does not provide explicit rules relating to pre-termination transfers between the estate and the debtor, the Secretary has authority pursuant to section 7805(a) to issue interpretative regulations under section 1398. The IRS and the Treasury Department believe the rules adopted in the final regulations are consistent with the overall system established by section 1398 and, in the absence of a contrary statutory provision, are a reasonable exercise of the Secretary's authority under section 7805(a). Moreover, the rules adopted in the final regulations are consistent with the only appellate court case on point, which holds that the transfer (other than by sale or exchange) of an asset from the estate to the debtor before the termination of the estate is a nontaxable disposition. See In re Olson, 100 B.R. 458 (Bankr. N.D. Iowa 1989), aff'd, 121 B.R. 346 (N.D. Iowa 1990), aff'd, 930 F.2d 6 (8th Cir. 1991).

III. Debtor's Succession to the Estate's Passive Activity Losses and Credits and Unused Section 465 Losses Before Termination of the Estate

 As a corollary to the treatment of the estate's transfer of an interest in a passive activity or former passive activity as a nontaxable disposition, the proposed regulations provide that if, before the termination of the estate, the estate transfers an interest in a passive activity or former passive activity to the debtor (other than by sale or exchange), the debtor succeeds to and takes into account the allocable portion of the estate's unused passive activity loss and credit attributable to the activity (determined as of the first day of the estate's taxable year in which the transfer occurs). The proposed regulations provide similar rules for section 465 losses.

 The objections submitted by one commentator generally parallel the previously discussed objections to the treatment of the estate's transfer of an interest in a passive activity or former passive activity before the termination of the estate as a nontaxable disposition. The final regulations retain the rules in the proposed regulations.

IV. Effective Date

 The provisions of sections 1.1398-1 and 1.1398-2 were proposed to be effective for bankruptcy cases commencing on or after November 9, 1992. Several commentators suggested alternative effective dates for the final regulations. One commentator recommended that a more appropriate effective date would be the date the regulations become final. Another commentator contended that, at least in certain situations, the regulations should be effective for bankruptcy cases commencing prior to November 9, 1992.

 The IRS and the Treasury Department believe that it is not necessary to delay the effective date because publication of the proposed regulations, which are being finalized without significant change, provided adequate notice of the new rules. In addition, limiting the application of the new rules to cases commenced after publication of the proposed regulations is clearly within the Treasury Department's authority to prescribe the extent to which regulations shall be applied without retroactive effect and conforms to the pattern of section 1398(g), which applies to cases commencing after March 25, 1981. Accordingly, the final regulations retain the effective date of the proposed regulations.

V. Joint Election to Have Sections 1.1398-1 and 1.1398-2 Apply to Cases Commenced Before November 9, 1992

 For cases commenced prior to November 9, 1992, and terminating on or after that date, the proposed regulations apply only if a joint election is made by the debtor and the estate. In cases under chapter 7, the election is valid only with the written consent of the bankruptcy trustee. In cases under chapter 11, the election is valid only if it is incorporated (a) into a bankruptcy plan that is confirmed by the bankruptcy court, or (b) into an order of the court. Additionally, the caption "ELECTION PURSUANT TO section 1.1398-1 (or section 1.1398-2)" must be placed prominently on the first page of each of the debtor's returns that is affected by the election (other than returns for taxable years that begin after the termination of the estate) and on the first page of each of the estate's returns that is affected by the election.

 One commentator recommended eliminating the requirement that the debtor join in the election. In general, this commentator felt that this requirement gave the debtor exclusive control over the passive activity losses and credits and unused section 465 losses to the detriment of the creditors.

 The final regulations retain the requirement that the debtor join in the election. This requirement permits debtors to rely on the law in effect at the time they entered into bankruptcy.

 One commentator suggested that because the consent of the debtor is required, the regulations should clarify that the written consent of the debtor is required in cases under chapter 7, in addition to the written consent of a bankruptcy trustee. The proposed regulations require the debtor to show consent by actually making the election. The debtor's election will be evidenced by the return on which it is made, and it is not clear what purpose would be served by an additional paperwork requirement. Accordingly, this suggestion was not adopted.

 A commentator requested clarification as to whether the election could be made on an amended return. In response to this comment, the regulations clarify that the election can be made on an amended return.

 Finally, a commentator requested that the regulations clarify whether the election is available for estates that are terminated after November 9, 1992, but before the adoption of final regulations. Because the regulations are sufficiently clear on this point, this comment was not adopted.

VI. Other Comments

 One commentator requested that the regulations provide guidance on the determination of basis under section 1398(g)(6), which provides that, in the case of assets acquired by the estate from the debtor, the estate succeeds to the debtor's basis, determined as of the first day of the debtor's taxable year in which the case commenced. The specific guidance requested concerned the effect on basis of events (such as depreciation or distributions received by the debtor as the result of holding an interest in a passthrough entity) that occur after the first day of the debtor's taxable year in which the case commenced, but prior to the commencement date. It was also requested that the regulations provide guidance on the application of the "varying interest" rule of section 706(d)(1) to the estate. This guidance is outside the scope of these regulations. Accordingly, the final regulations do not provide guidance on these issues.

SPECIAL ANALYSIS

 It has been determined that these final regulations are not significant rules as defined in EO 12866. Therefore, a regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations. Therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, a copy of the proposed rules was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

DRAFTING INFORMATION

 The principal author of these regulations is Amy J. Sargent of the Office of Assistant Chief Counsel (Income Tax and Accounting), IRS. However, other personnel from the IRS and Treasury Department participated in their development.

LIST OF SUBJECTS

26 CFR Part 1

 Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

 Reporting and recordkeeping requirements.

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1 -- INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. An undesignated center heading is added immediately following section 1.1388-1 to read as follows:

"Rules Relating to Individuals' Title 11 Cases"

Par. 3. Sections 1.1398-1 and 1.1398-2 are added to read as follows:

SECTION 1.1398-1 TREATMENT OF PASSIVE ACTIVITY LOSSES AND PASSIVE ACTIVITY CREDITS IN INDIVIDUALS' TITLE 11 CASES.

(a) SCOPE. This section applies to cases under chapter 7 or chapter 11 of title 11 of the United States Code, but only if the debtor is an individual.

(b) DEFINITIONS AND RULES OF GENERAL APPLICATION. For purposes of this section --

(1) PASSIVE ACTIVITY and FORMER PASSIVE ACTIVITY have the meanings given in section 469(c) and (f)(3);

(2) The unused passive activity loss (determined as of the first day of a taxable year) is the passive activity loss (as defined in section 469(d)(1)) that is disallowed under section 469 for the previous taxable year; and

(3) The unused passive activity credit (determined as of the first day of a taxable year) is the passive activity credit (as defined in section 469(d)(2)) that is disallowed under section 469 for the previous taxable year.

(c) ESTATE SUCCEEDS TO LOSSES AND CREDITS UPON COMMENCEMENT OF CASE. The bankruptcy estate (estate) succeeds to and takes into account, beginning with its first taxable year, the debtor's unused passive activity loss and unused passive activity credit (determined as of the first day of the debtor's taxable year in which the case commences).

(d) TRANSFERS FROM ESTATE TO DEBTOR -- (1) TRANSFER NOT TREATED AS TAXABLE EVENT. If, before the termination of the estate, the estate transfers an interest in a passive activity or former passive activity to the debtor (other than by sale or exchange), the transfer is not treated as a disposition for purposes of any provision of the Internal Revenue Code assigning tax consequences to a disposition. The transfers to which this rule applies include transfers from the estate to the debtor of property that is exempt under section 522 of title 11 of the United States Code and abandonments of estate property to the debtor under section 554(a) of such title.

(2) TREATMENT OF MASSIVE ACTIVITY LOSS AND CREDIT. If, before the termination of the estate, the estate transfers an interest in a passive activity or former passive activity to the debtor (other than by sale or exchange) --

(i) The estate must allocate to the transferred interest, in accordance with section 1.469-1(f)(4), part or all of the estate's unused passive activity loss and unused passive activity credit (determined as of the first day of the estate's taxable year in which the transfer occurs); and

(ii) The debtor succeeds to and takes into account, beginning with the debtor's taxable year in which the transfer occurs, the unused passive activity loss and unused passive activity credit (or part thereof) allocated to the transferred interest.

(e) DEBTOR SUCCEEDS TO LOSS AND CREDIT OF THE ESTATE UPON ITS TERMINATION. Upon termination of the estate, the debtor succeeds to and takes into account, beginning with the debtor's taxable year in which the termination occurs, the passive activity loss and passive activity credit disallowed under section 469 for the estate's last taxable year.

(f) EFFECTIVE DATE -- (1) CASES COMMENCING ON OR AFTER NOVEMBER 9, 1992. This section applies to cases commencing on or after November 9, 1992.

(2) CASES COMMENCING BEFORE NOVEMBER 9, 1992 -- (i) ELECTION REQUIRED. This section applies to a case commencing before November 9, 1992, and terminating on or after that date if the debtor and the estate jointly elect its application in the manner prescribed in paragraph (f)(2)(v) of this section (the election). The caption "ELECTION PURSUANT TO section 1.1398-1" must be placed prominently on the first page of each of the debtor's returns that is affected by the election (other than returns for taxable years that begin after the termination of the estate) and on the first page of each of the estate's returns that is affected by the election. In the case of returns that are amended under paragraph (f)(2)(iii) of this section, this requirement is satisfied by placing the caption on the amended return.

(ii) SCOPE OF ELECTION. This election applies to the passive and former passive activities and unused passive activity losses and passive activity credits of the taxpayers making the election.

(iii) AMENDMENT OF PREVIOUSLY FILED RETURNS. The debtor and the estate making the election must amend all returns (except to the extent they are for a year that is a closed year within the meaning of paragraph (f)(2)(iv)(D) of this section) they filed before the date of the election to the extent necessary to provide that no claim of a deduction or credit is inconsistent with the succession under this section to unused losses and credits. The Commissioner may revoke or limit the effect of the election if either the debtor or the estate fails to satisfy the requirement of this paragraph (f)(2)(iii).

(iv) RULES RELATING TO CLOSED YEARS -- (A) ESTATE SUCCEEDS TO DEBTOR'S PASSIVE ACTIVITY LOSS AND CREDIT AS OF THE COMMENCEMENT DATE. If, by reason of an election under this paragraph (f), this section applies to a case that was commenced in a closed year, the estate, nevertheless, succeeds to and takes into account the unused passive activity loss and unused passive activity credit of the debtor (determined as of the first day of the debtor's taxable year in which the case commenced).

(B) NO REDUCTION OF UNUSED PASSIVE ACTIVITY LOSS AND CREDIT FOR PASSIVE ACTIVITY LOSS AND CREDIT NOT CLAIMED FOR A CLOSED YEAR. In determining a taxpayer's carryover of a passive activity loss or credit to its taxable year following a closed year, a deduction or credit that the taxpayer failed to claim in the closed year, if attributable to an unused passive activity loss or credit to which the taxpayer succeeded under this section, is treated as a deduction or credit that was disallowed under section 469.

(C) PASSIVE ACTIVITY LOSS AND CREDIT TO WHICH TAXPAYER SUCCEEDS REFLECTS DEDUCTIONS OF PRIOR HOLDER IN A CLOSED YEAR. A loss or credit to which a taxpayer would otherwise succeed under this section is reduced to the extent the loss or credit was allowed to its prior holder for a closed year.

(D) CLOSED YEAR. For purposes of this paragraph (f)(2)(iv), a taxable year is closed to the extent the assessment of a deficiency or refund of an overpayment is prevented, on the date of the election and at all times thereafter, by any law or rule of law.

(v) MANNER OF MAKING ELECTION -- (A) CHAPTER 7 CASES. In a case under chapter 7 of title 11 of the United States Code, the election is made by obtaining the written consent of the bankruptcy trustee and filing a copy of the written consent with the returns (or amended returns) of the debtor and the estate for their first taxable years ending after November 9, 1992.

(B) CHAPTER 11 CASES. In a case under chapter 11 of title 11 of the United States Code, the election is made by incorporating the election into a bankruptcy plan that is confirmed by the bankruptcy court or into an order of such court and filing the pertinent portion of the plan or order with the returns (or amended returns) of the debtor and the estate for their first taxable years ending after November 9, 1992.

(vi) ELECTION IS BINDING AND IRREVOCABLE. Except as provided in paragraph (f)(2)(iii) of this section, the election, once made, is binding on both the debtor and the estate and is irrevocable.

SECTION 1.1398-2 TREATMENT OF SECTION 465 LOSSES IN INDIVIDUALS' TITLE 11 CASES.

(a) SCOPE. This section applies to cases under chapter 7 or chapter 11 of title 11 of the United States Code, but only if the debtor is an individual.

(b) DEFINITION AND RULES OF GENERAL APPLICATION. For purposes of this section --

(1) SECTION 465 ACTIVITY means an activity to which section 465 applies; and

(2) For each section 465 activity, the unused section 465 loss from the activity (determined as of the first day of a taxable year) is the loss (as defined in section 465(d)) that is not allowed under section 465(a)(1) for the previous taxable year.

(c) ESTATE SUCCEEDS TO LOSSES UPON COMMENCEMENT OF CASE. The bankruptcy estate (the estate) succeeds to and takes into account, beginning with its first taxable year, the debtor's unused section 465 losses (determined as of the first day of the debtor's taxable year in which the case commences).

(d) TRANSFERS FROM ESTATE TO DEBTOR -- (1) TRANSFER NOT TREATED AS TAXABLE EVENT. If, before the termination of the estate, the estate transfers an interest in a section 465 activity to the debtor (other than by sale or exchange), the transfer is not treated as a disposition for purposes of any provision of the Internal Revenue Code assigning tax consequences to a disposition. The transfers to which this rule applies include transfers from the estate to the debtor of property that is exempt under section 522 of title 11 of the United States Code and abandonments of estate property to the debtor under section 554(a) of such title.

(2) TREATMENT OF SECTION 465 LOSSES. If, before the termination of the estate, the estate transfers an interest in a section 465 activity to the debtor (other than by sale or exchange) the debtor succeeds to and takes into account, beginning with the debtor's taxable year in which the transfer occurs, the transferred interest's share of the estate's unused section 465 loss from the activity (determined as of the first day of the estate's taxable year in which the transfer occurs). For this purpose, the transferred interest's share of such loss is the amount, if any, by which such loss would be reduced if the transfer had occurred as of the close of the preceding taxable year of the estate and been treated as a disposition on which gain or loss is recognized.

(e) DEBTOR SUCCEEDS TO LOSSES OF THE ESTATE UPON ITS TERMINATION. Upon termination of the estate, the debtor succeeds to and takes into account, beginning with the debtor's taxable year in which the termination occurs, the losses not allowed under section 465 for the estate's last taxable year.

(f) EFFECTIVE DATE -- (1) CASES COMMENCING ON OR AFTER NOVEMBER 9, 1992. This section applies to cases commencing on or after November 9, 1992.

(2) CASES COMMENCING BEFORE NOVEMBER 9, 1992 -- (i) ELECTION REQUIRED. This section applies to a case commencing before November 9, 1992, and terminating on or after that date if the debtor and the estate jointly elect its application in the manner prescribed in paragraph (f)(2)(v) of this section (the election). The caption "ELECTION PURSUANT TO section 1.1398-2" must be placed prominently on the first page of each of the debtor's returns that is affected by the election (other than returns for taxable years that begin after the termination of the estate) and on the first page of each of the estate's returns that is affected by the election. In the case of returns that are amended under paragraph (f)(2)(iii) of this section, this requirement is satisfied by placing the caption on the amended return.

(ii) SCOPE OF ELECTION. This election applies to the section 465 activities and unused losses from section 465 activities of the taxpayers making the election.

(iii) AMENDMENT OF PREVIOUSLY FILED RETURNS. The debtor and the estate making the election must amend all returns (except to the extent they are for a year that is a closed year within the meaning of paragraph (f)(2)(iv)(D) of this section) they filed before the date of the election to the extent necessary to provide that no claim of a deduction is inconsistent with the succession under this section to unused losses from section 465 activities. The Commissioner may revoke or limit the effect of the election if either the debtor or the estate fails to satisfy the requirement of this paragraph (f)(2)(iii).

(iv) RULES RELATING TO CLOSED YEARS -- (A) ESTATE SUCCEEDS TO DEBTOR'S SECTION 465 LOSS AS OF THE COMMENCEMENT DATE. If, by reason of an election under this paragraph (f), this section applies to a case that was commenced in a closed year, the estate, nevertheless, succeeds to and takes into account the section 465 losses of the debtor (determined as of the first day of the debtor's taxable year in which the case commenced).

(B) NO REDUCTION OF UNUSED SECTION 465 LOSS FOR LOSS NOT CLAIMED FOR A CLOSED YEAR. In determining a taxpayer's carryover of an unused section 465 loss to its taxable year following a closed year, a deduction that the taxpayer failed to claim in the closed year, if attributable to an unused section 465 loss to which the taxpayer succeeds under this section, is treated as a deduction that was not allowed under section 465.

(C) LOSS TO WHICH TAXPAYER SUCCEEDS REFLECTS DEDUCTIONS OF PRIOR HOLDER IN A CLOSED YEAR. A loss to which a taxpayer would otherwise succeed under this section is reduced to the extent the loss was allowed to its prior holder for a closed year.

(D) CLOSED YEAR. For purposes of this paragraph (f)(2)(iv), a taxable year is closed to the extent the assessment of a deficiency or refund of an overpayment is prevented, on the date of the election and at all times thereafter, by any law or rule of law.

(v) MANNER OF MAKING ELECTION -- (A) CHAPTER 7 CASES. In a case under chapter 7 of title 11 of the United States Code, the election is made by obtaining the written consent of the bankruptcy trustee and filing a copy of the written consent with the returns (or amended returns) of the debtor and the estate for their first taxable years ending after November 9, 1992.

(B) CHAPTER 11 CASES. In a case under chapter 11 of title 11 of the United States Code, the election is made by incorporating the election into a bankruptcy plan that is confirmed by the bankruptcy court or into an order of such court and filing the pertinent portion of the plan or order with the returns (or amended returns) of the debtor and the estate for their first taxable years ending after November 9, 1992.

(vi) ELECTION IS BINDING AND IRREVOCABLE. Except as provided in paragraph (f)(2)(iii) of this section, the election, once made, is binding on both the debtor and the estate and is irrevocable.

PART 602 -- OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 4. The authority citation for part 602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 5. In section 602.101(c), entries are added to the table in numerical order to read as follows:

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